Empirical evidence on the corporate use of derivatives.
* The last decade has seen a dramatic increase in the use of derivative securities by corporations. There has been a similar increase in the number of research studies addressing if, and how, firms should engage in risk management. The standard view, based on the insights of Modigliani and Miller (1958), is that financial policy decisions only affect how the value of the firm is divided among its claimholders. Recent theoretical studies, however, argue that risk management can add value to a firm if there are capital market imperfections such as costs of financial distress, progressive tax rates, and conflicts of interest between shareholders and senior claimholders.(1)
Several empirical studies attempt to test whether firms' behavior is consistent with prescriptions based on theoretical risk management studies. Nance, Smith, and Smithson (1993) provide the most comprehensive empirical test of these theories.(2) They survey 169 firms from the Fortune 500 and the S&P 400 in 1986. The results indicate that firms using hedging instruments face more convex tax functions and have higher dividend yields. Most of the other variables used in their model have signs that are consistent with theory, but are not statistically significant. Nance et al. (1993) suggest that because of data constraints, the results are not very powerful. In particular, the use of survey data introduces a sampling bias, and the binary dependent variable in their study does not represent the extent to which firms hedge.
This paper presents an empirical study of the determinants of the corporate use of financial derivatives. Our paper does not suffer from the data limitations of prior research. We use a data set from New Zealand, where firms are required to report the fair value and the contract (notional) value of their off- and on-balance sheet financial instruments.(3) Thus, our data are collected from audited financial statements and do not have the non-response bias inherent in survey designs.(4) The use of audited disclosures also enables us to develop a continuous measure for hedging activity, compared to the binary dependent variable used in prior research. Furthermore, we extend prior research by including other explanatory variables that we expect to influence the corporate hedging decision. Specifically, we test (1) the managerial risk-aversion hypothesis (Smith and Stulz, 1985); (2) the relation between the use of derivatives and the level of foreign activities, and (3) the need to coordinate investing and financing policies (Froot, Scharfstein and Stein, 1993).
In line with theoretical models of corporate risk management, we find that derivative use increases with leverage, size, the existence of tax losses, the proportion of shares held by directors, and the payout ratio. The corporate use of derivatives decreases with interest coverage and liquidity. Only when we use fair value as the measure of hedging activity, do we find support for the hypothesis that derivative use is positively related to the value of a firm,s growth options. We find that short-term asset growth, the proportion of foreign assets to total assets, and the use of alternative capital instruments are not related to derivative use. The results are largely insensitive to the way in which we measure the use of derivatives.
In Section I, we provide a brief background to the New Zealand financial markets and accounting policy rules concerning the disclosure of financial instruments. Section II discusses incentives for firms to hedge using financial instruments and summarizes these in the form of testable hypotheses. Section III contains details of the sample, variables measurement, and results. We present our conclusions in Section IV.
I. Institutional Background
New Zealand has an open economy, in which exports mainly comprise basic commodities such as wool, timber, and agricultural produce. In 1994, imports were 29% of GDP and exports were 31%. Furthermore, interest-rate and foreign-exchange volatility are relatively high. For example, the annualized volatility of short@term interest rates over the period January 1993 to January 1996 is 5.4% for New Zealand. For the U.S., this number is 4.3%, and for Japan, 3.1%. Thus, New Zealand firms are exposed to several risks which can be managed by derivative instruments.
The use of financial derivatives has grown dramatically since the deregulation of New Zealand financial markets in 1984. Over the period June 1987 to June 1994, the notional amount of swaps held by financial institutions increased from $2,350 million to $39,710 million; options and futures increased from $6,436 million to $29,106 million; and forward contracts increased from $53,718 million to $143,076 million. By comparison, the on-balance sheet assets held by financial institutions increased from $61,090 million to $96,996 million during the same period.(5)
Data on the corporate use of derivative financial instruments have recently become available in the audited financial statements of New Zealand firms. Financial Reporting Standard No. 31, Disclosure of Information about Financial Instruments, requires aggregate disclosures of the contract and fair values of on- and off-balance sheet financial instruments for financial reports covering periods ending on or after 31 December 1993.
II. Incentives for Hedging
Under the assumptions of Modigliani and Miller (1958), no financial contract can alter firm value. Hedging activities can only result in an increase in firm value if there are certain market imperfections. Smith and Stulz (1985), Bessembinder (1991), and Froot et al. (1993) identify four imperfections that might give rise to the use of derivatives: (1) When there are costs of financial distress, (2) when effective corporate tax rates are progressive, (3) when there are conflicts of interest between equity holders and senior claim holders, and (4) when risk-averse agents who contract with the firm cannot fully diversify their claims. We briefly discuss each of these arguments and other factors that could influence the use of derivatives for hedging purposes.
In addition to derivatives, we note that firms can engage in corporate risk management by changing their operating and financing strategies. In this study, we take these strategies as predetermined. A firm has much more flexibility in adjusting size, maturity, and/ or denomination of its financial instruments than in adjusting its operating and financing strategies. Thus, it is likely that financial instruments are used to manage the risk profile of the firm after operating and financing decisions have been made.
A. Expected Costs of Financial Distress
Hedging can reduce the expected costs of financial distress by reducing the variance of firm value and, with that, the probability that the firm will encounter financial distress (Smith and Stulz, 1985). The benefits of hedging will increase if a firm faces higher costs of financial distress.
Nance et al. (1993) argue that smaller firms are more likely to hedge than larger firms, because the direct costs of financial distress are less than proportional to firm size. (See Warner, 1977 and Ang, Chua, and McConnell, 1982.) However, empirical evidence suggests a positive relationship between size and the use of derivatives (for example, Nance et al., 1993). There are several explanations for this result. First, indirect costs of financial distress are likely to be much larger than the direct costs associated with bankruptcy (see, for example, Altman, (1984). If there is no scale effect for indirect costs of bankruptcy, then firm size might not be a useful proxy for the costs of financial distress. Second, larger firms have more sophisticated financial management practices and are therefore more likely to use derivatives. Finally, we expect a positive relation between size and derivative use because the markets for derivatives show significant scale economies in the structure of transaction costs.
We use leverage and the interest-cover ratio as our measures of the probability of financial distress. Debt agreements typically include covenants that use these ratios to define states of financial distress. Also, bankruptcy protection models support the use of leverage and interest cover ratios.(6)
B. Progressive Tax Rates
If a firm,s effective tax schedule is convex, then expected taxes can be reduced by hedging (Smith and Stulz, 1985). New Zealand does not have a progressive corporate tax schedule, neither are there tax concessions such as an investment tax credit. Many firms, however, have tax-loss carryforwards. Since the effective tax schedule of these firms is convex, they are more likely to use derivative instruments to reduce the variability of their taxable income and maximize the present value of their tax losses.
C. Investment Opportunity Set
The firm's investment opportunity set affects the conflict of interest between the firm's fixed and residual claimholders. Myers (1977) dichotomizes the firm's investments into assets in place and growth options and demonstrates that shareholders have the incentive to underinvest (i.e., forego positive net present value projects) if the gains accrue primarily to debtholders. By entering into derivative contracts, the firm can redistribute cash from states in which cash flow exceeds obligations to states with insufficient cash flow. As a result, corporate hedging reduces the incentive to underinvest by increasing the number of future states in which equity holders are the residual claimholders (Bessembinder, 1991). We therefore predict increased use of derivatives for firms with high leverage and valuable growth options, because these firms are more likely to be affected by the underinvestment problem.
Froot et al. (1993) take a different point of view. They argue that the volatility of future cash flows only constitutes a problem to the extent that it could unexpectedly reduce the amount of internally generated cash, thereby compromising the firm's ability to make value@increasing investments. That is, it is not the existence of growth options per se that is a determinant of corporate hedging, but the risk of not being able to convert growth options into assets in place. Our empirical model includes a proxy for both the value of the firm,s growth options and its ability to convert growth options into assets in place.
D. Diversification of Contracting Parties
Several parties contracting with the firm might be unable to fully diversify the risks inherent in their claim on the firm. These parties (e.g., managers, employees, suppliers, and customers) require additional compensation for bearing nondiversifiable risk. In this situation, reducing the variability of the firm's value by hedging increases the firm's value if the cost of hedging is smaller than the reduction in the extra compensation of the contracting parties (Smith and Stulz, 1985).
One group that warrants special attention is the firm's management. In most cases, it is the managers who make the corporate hedging decisions. The optimal hedging decision from the management perspective depends on the compensation contract. In a simple two-period model, Smith and Stulz show that if the managers' end-of-period wealth is a concave function of firm value, it is optimal for them to completely hedge the value of the firm. In the case of a convex function, the manager might be better off if the firm is not hedged at all. This latter situation could occur if management owns stock options, or if they have a compensation plan with option-like characteristics (e.g., they receive a bonus if accounting earnings exceed a certain target level).
E. Other Factors
In this section, we discuss other factors that can influence the demand for derivative financial instruments to hedge corporate activities.
1. Hedging Substitutes
Nance et al. (1993) suggest that a firm can reduce the conflict between shareholders and bondholders by means other than hedging with financial instruments. For instance, firms can reduce the agency conflict between shareholders and bondholders by issuing convertible bonds or preferred stock.
Dividend policy also influences a firm's need to hedge. A lower dividend payout makes it more likely that funds will be available to pay the fixed claimholders, and might therefore reduce the agency conflict. It is interesting to note that although Nance et al. (1993) discuss this issue in terms of the payout ratio, they use the dividend yield to test this hypothesis. The dividend yield, however, could be proxying for both growth opportunities (a price-earnings effect) and dividend restrictions (a dividend payout effect).(7) To avoid this problem, we use both variables in our analysis.
Liquidity is the third hedging substitute variable. Some studies argue that a firm with more liquid assets is less likely to engage in risk management, since it has a larger financial buffer.
2. Nature of Operations
The nature of operations can also influence the level of derivatives used. For example, firms that import or export and firms with overseas subsidiaries are more likely to use derivatives to manage foreign currency exposures.
III. Sample, Variable Measurement,
We sample all firms listed on the New Zealand Stock Exchange. We exclude foreign firms, as they are not subject to the same financial disclosure rules as local firms, and firms in the financial services sector because their financial characteristics and derivatives use are very different from other corporations. Three firms did not disclose any information on financial instruments. Of the remaining 116, 55 firms (48%) held derivative financial instruments at balance date.
The firms in our sample come from a broad range of industries. Most important are transportation and tourism (11); mining and exploration (10): the food industry (9); the retail sector (8); and agriculture, property, and forestry (each 7). None of the firms in the sample indicate that derivative financial instruments are used for speculative purposes.
B. Dependent Variable
The ideal measure of derivative usage is the hedge ratio of the contracts entered into to manage risk exposures. Since this information is unavailable, we measure hedging activity by the fair and contract values of the derivatives outstanding at balance date, scaled by the market value of the firm.
The fair value measure is defined as the absolute value of the net gain or loss on all derivatives (forwards, futures, swaps, and options) outstanding at balance date, scaled by the market value of the firm. It is an ex post estimate of the net result of using derivatives and gives an unbiased measure of the extent to which a firm manages its "value at risk" using derivatives. Note, however, that the fair value measure is potentially very noisy, because it depends on two factors that are unrelated to the actual hedge ratio of the derivatives position@ the past movement of the risk variable being managed, and the time elapsed since the inception of the derivative contracts. If the time elapsed or the movement of the risk variable is minimal, the fair value can be small even if the hedge ratio of the derivatives position is large. Nevertheless, the fair value gives an unbiased measure that is potentially useful in a cross-sectional model.
Our second measure employs the sum of the contract (notional) values of all derivatives outstanding at balance date. Again, we scale this number by the market value of the firm. Although this measure does not have an ex post nature like the fair value, it too is imperfect. The contract amount aggregates short and long positions. It does not take into account the risk characteristics of the contract, as there is no information on the term, denomination and settlement price of the outstanding contracts. For example, in the case of swaps, the contract amount can be very large, whereas the net,, position may be limited. Where hedging is undertaken at a decentralized level, the reported contract value of derivatives may be larger than if hedging is undertaken at a group level. Yet the same net position and fair value may result.
Table 1 provides descriptive statistics of the level of financial derivatives held at fiscal year-end. The fair values range from zero to 8% of the market value of the firm. The mean is 0.3% for the whole sample and 0.5% for those firms that hold derivatives at balance date. The contract amounts range from zero to 96% of the market value of the firm, with a mean of nearly 10% for the whole sample and a mean of 22% for those firms that hold derivative instruments.
Table 1. Descriptive Statistics of the Use of Derivatives
The table contains descriptive statistics of the fair value and contract value of derivative instruments held at balance date, scaled by the market value of the firm.
Panel A. All Sample Firms (N=116) Mean Std. Dev. Min. Max. Fair Value 0.003 0.011 0.000 0.083 Contract Value 0.094 0.184 0.000 0.963 Panel B. Firms with Derivative Instruments (N=55) Mean Std. Dev. Min. Max. Fair Value 0.005 0.013 0.000 0.083 Contract Value 0.220 0.227 0.001 0.963
C. Independent Variables
Table 2 reports descriptive statistics for the independent variables that we use in our empirical model. For each of these variables, Table 3 reports the means and the medians for the firms that use derivatives and for those that do not. The significance of the differences in the medians for these two groups is assessed using a nonparametric Mann-Whitney U test.
[TABULAR DATA NOT REPRODUCIBLE IN ASCII]
We use three measures to proxy for the expected costs of financial distress@ firm size, interest cover, and leverage. The market value of the firm is measured as the log of the sum of the market value of equity, value of debt, and preference capital. Interest cover is defined as the log of the earnings before interest and tax over the interest expense.(8) Leverage is measured as the book value of debt over the market value of the firm. Table 3 shows that firms with derivatives are significantly larger and have higher leverage than firms without derivatives. Interest cover for firms using derivatives is lower but not significant.
Forty-four firms (38%)in our sample have tax-loss carryforwards. For these firms, the tax loss variable equals one and zero otherwise. The use of a dummy variable avoids the scaling problem noted by Nance et al. (1993) and might be more appropriate. Hedging for periods greater than one year might reduce the volatility of future taxable income but is likely to increase liquidity risk.(9) Hence, regardless of the total value of tax losses available, the firm is only likely to use derivatives to reduce the volatility of next year's assessable income. Furthermore, in New Zealand, financial instruments are marked to market every year for tax purposes. Hedging for terms longer than one year might therefore result in an unwanted increase in the variability of the after-tax cash flows. Table 3 indicates that firms with derivatives are more likely to have tax losses carried forward.
To capture the firm,s investment opportunity set, we employ two variables. An earnings price ratio is used to proxy for the long term growth prospects of the firm.(10) Froot et al. (1993) argue that risk management should focus more on the short term. Their view is that the purpose of the risk management program is to ensure that the firm has the cash it needs to make value-increasing investments. We use the log of the ratio of the current year,s change in net tangible assets plus depreciation to net income plus depreciation as a proxy for the firm,s ability to generate enough cash to finance its current investment programs.(11) Table 3 shows that the earnings@price ratio is higher for the firms with derivatives and, also contrary to expectations, our measure for the ability to finance short-term asset growth is lower for firms with derivatives.
To proxy for the diversification of contracting parties we use the proportion of shares held by directors. We expect that directors who hold a greater proportion of shares are more concerned about the variability of firm value and are therefore more likely to hedge. However, contrary to expectations, Table 3 indicates that the proportion of shares held by directors is lower for firms with derivatives.(12)
Following Nance et al. (1993) we employ several variables to capture substitutes for hedging activity. We define liquidity as the log of current assets minus inventory over current liabilities.(13) We calculate payout as dividends per share divided by earnings per share. The use of quasi equity in the capital structure is measured as the value of convertible bonds plus preferred stock as a percentage of firm value. In Table 3, the firms with derivatives are less liquid, have higher dividend payout and greater proportions of alternative capital instruments. Finally, we include the involvement in overseas activities by the proportion of overseas assets.(14) Table 3 indicates that firms with derivatives have more overseas assets.
Table 4 presents the correlation matrix of the independent variables. The smallest correlation is -0.357 between leverage and liquidity, and the largest is 0.313 between interest cover and the earnings-price ratio. Only five correlations have an absolute value larger than 0.3. This suggests that multicollinearity is present in the data, but that it is not severe.
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D. Tobit Model Results
As discussed in the previous section, a large number of firms do not use derivatives. Our dependent variables are therefore left@censored, which requires the use of a Tobit model. More specifically, the dependent variable is defined as:
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In Equation 1, [y.sub.i], is the hedging activity of firm i. Hedging activity is measured in two ways: The fair value of the contracts outstanding at balance date, and the nominal or principal amount of the contracts outstanding at balance date. [Beta] is a vector of unknown parameters, [x.sub.i] is the vector of independent variables, and [u.sub.i] are residuals that are independently and normally distributed, with mean zero and variance [[Sigma].sub.[Mu].sup.2]
Twelve firms in our sample did not report the fair value of the derivative instruments outstanding at balance date, but did report the contract value. Since the financial statements were audited, the most likely reason for the nondisclosure is that the amounts were immaterial. Table 5, Model A reports the Tobit regression results using the fair value as dependent variable, excluding these 12 non-disclosing firms.(15) Table 5, Model B reports the regression results using the contract amount as the dependent variable.
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Table 5, Model A shows that using the fair value as a measure of hedging activity, the coefficients for firm size, interest cover, leverage, tax loss, and liquidity are in the direction hypothesized and are significant at the 5% level. Similarly, the coefficients for earnings@price ratio and dividend payout are significant at the 10% level. Management share ownership is significant just beyond the 10% level. We do not find any relation between the level of hedging activity and our measure of the ability of the firm to finance its current investment program, as measured by the asset growth to cash flow ratio. We also find no relation between the level of hedging activity, the use of alternative capital instruments, and the proportion of overseas assets.
The results in Model B are based on contract amounts as the measure of hedging activity and are very similar to Model A. The most important difference is that although the parameters for managerial share ownership and liquidity have the predicted signs, they are no longer different from zero at conventional levels of significance. Furthermore, the coefficient for the earnings-price ratio is no longer significant and, contrary to expectations, has a positive sign.
Overall, the results in Table @ give strong support for the view that firms use derivatives to reduce the cost of financial distress and to increase the present value of tax losses. Furthermore, the results suggest that a high proportion of liquid assets and a low dividend payout ratio reduce the need to use derivatives to lower agency costs. The results give some support to the idea that managers try to reduce the variability of the firm value if they are part-owners of the firm. Only when we use fair value as the measure of hedging activity, do we find support for the hypothesis that derivative use is positively related to the value of a firm's growth options. We find no relation between hedging activity and the ability of the firm to finance its current investment program, the use of alternative capital instruments, and the proportion of overseas assets. Our findings are mostly independent of the way in which we measure derivatives use. Only the results on the earnings-price ratio are ambiguous.
Recent finance theories suggest that hedging can increase firm value by reducing the uncertainty of expected taxable income, the expected costs of financial distress, and agency costs. This study provides nonsurvey evidence on the use of derivative financial instruments by New Zealand corporations. We use the fair value and the contract (notional) value scaled by the market value of the firm to measure the level of derivative use. The results are generally insensitive to our measure of derivatives use and are consistent with theoretical models of corporate risk management. Corporate derivative use increases with leverage, size, the existence of tax losses, the proportion of shares held by directors, and the payout ratio and decreases with interest coverage and liquidity. Only when we use the fair value as the measure of hedging activity, do we find support for the hypothesis that derivatives use is positively related to the value of a firm,s growth options. We find that short-term asset growth, foreign assets as a proportion of total assets, and the use of alternative equity instruments are not related to the use of derivatives.
(1) See, for example, Stulz (1984); Smith and Stulz (1985); Bessembinder (1991); and Froot, Scharfstein, and Stein (1993).
(2) Earlier empirical research has used survey and field study data to describe the corporate use of derivatives (see, for example, Jilling, 1978; Rodriguez, 1981; and Block and Gallager, 1986). Recent evidence on derivatives usage by U.S. nonfinancial firms is reported in Bodnar, Hayt, Marston, and Smithson (1995) and Phillips (1995).
(3) The fair value gives the net gain or loss on the derivative contracts outstanding at balance date. The contract value is the notional value or principal amount of the derivative contracts outstanding at balance date.
(4) Nance et al. (1993) achieve a 31.6% useable response rate in their survey. Similar rates are achieved in other studies (e.g., 38.6% in Block and Gallagher, 1986; and 26.5% in Bodnar, Hayt, Marston, and Smithson, 1995).
(5) The amounts are expressed in New Zealand dollars. Data on the values of derivative financial instruments are taken from the Reserve Bank of New Zealand Statistics and represent the sum of of- and on-balance sheet amounts held by financial institutions. The Reserve Bank first reported such information in 1987.
(6) See Zagren (1983) for a review of this literature. The results in Opler and Titman (1994) suggest that leverage is associated with the indirect cost of bankruptcy.
(7) Dividend yield is the product of the earnings-price ratio and the dividend payout ratio.
(8) Earnings before interest and taxes is set equal to one (1) if it is negative and interest is set equal to one (1) if the firm has no debt.
(9) A good example of this problem is the maturity mismatch between Metaligesschaft's long-term exposure to price risk and its hedge portfolio of short-term instruments. (See Meelo and Parsons, 1995.)
(10) Nance et al. (1993) also employ the ratio of research and development expenditure to firm value. We cannot use a similar variable as there is no reporting requirement for New Zealand firms to disclose research and development exependiture.
(11) If the change in tangible assets plus depreciation is negative, it is set equal to zero. If net income plus depreciation is negative, it is set equal to one. We also used percentage growth in tangible assets as a measure of asset growth and obtained results similar to those reported.
(12) We undertook additional analysis combining the proportion of shares held by directors and those held by employee share and ownership plans. We also used the proportion of shares held by the top 20 shareholders. None of these variables has any explanatory power.
(13) This measure differs slightly from Nance et al. (1993), who measure liquidity as current assets over current liabilities. We exclude inventory from current assets, as the "quick ratio" is considered a better measure of liquidity in accounting texts.
(14) We obtain this data from geographical segment data in the financial report. We also tested foreign sales as a proportion of total sales as a measure of overseas activity. This variable is highly correlated with the proportion of overseas assets and leads to the same conclusions.
(15) As a check on this regression, we included these firms with a very small, but positive, fair value (i.e., $1,000). This adjustment does not materially alter the results.
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Henk Berkman is a Senior Lecturer in the Department of Accounting and Finance, University of Auckland, Auckland, New Zealand. Michael E. Bradbury is a Professor in the Department of Accounting and Finance, University of Auckland, Auckland, New Zealand.
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|Author:||Berkman, Henk; Bradbury, Michael E.|
|Date:||Jun 22, 1996|
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